Junk bonds aren't exactly the trash of the fixed income world of investing. In fact, buying the right junk bond fund can be a smart move for a diversified portfolio. Bonds are debt securities issued by corporations, governments, and municipalities and purchased by investors.
Junk Bond Definition
Also known as high yield, junk bonds are bonds that have credit quality ratings below investment grade—a rating below BBB by Standard & Poor's or below Baa by Moody's credit rating agencies. Bond ratings of AAA are the highest quality offerings. A bond can receive a lower credit rating because of the risk of default on the part of the entity issuing the bond. Therefore, because of this higher relative risk, the entities issuing these bonds will pay higher interest rates to compensate the investors for taking the risk of buying the bonds, thus the name high yield.
Think of a personal credit score. Individuals with poor credit history, or those whose financial positions are weak, will be given lower credit scores and will be charged higher interest rates for borrowing. The same rationale is followed by the agencies giving credit quality ratings to the bond-issuing entities. Poor credit history or weak financial position equals higher interest rates for borrowers. In the case of bonds, the issuing entity is the borrower and the bond investor is the lender.
Conversely, the high credit quality bonds are above investment grade. Entities with high ratings will be rewarded by paying lower interest rates for borrowing.
Investment Strategy, Timing & Risks
The fundamental rationale for investing in securities with higher relative risk is simple to understand—higher relative risk can translate into higher relative returns. However, the world of fixed income is a complex one. The market risks of investing in junk bonds and high yield bond mutual funds are widely misunderstood.
The Fed and Bond Prices
Bond fund prices are related to interest rates and inflation. Bond prices move in the opposite direction as bond yields. Through the actions of the Federal Reserve, interest rates can be increased or decreased. The Fed does this to slow down an overheated economy or to stimulate a weak one, respectively. The changes are whichever is appropriate in The Fed's judgment of prevailing economic conditions. Interest rates are generally rising during periods of strong economic growth and are generally declining in recessionary environments.
The Markets and Bond Prices
Investors and capital markets also affect bond prices and yields. Investors are not as willing to pay as much for a high-risk bond but they are willing to pay more for low-risk bonds. Think of recessionary periods—where the investor herd is moving away from perceived risk and toward perceived safety.
As more and more investors demand "safety," the demand pushes the safe investment product's price higher and its yield lower. These investors move to the safest investments with the highest credit ratings, such as U.S. Treasuries.
When economies begin to look healthy again, investors increasingly move out of perceived safety and into higher risk areas. This pushes the higher risk (i.e. junk bond) prices higher and the opposite occurs for the "safe" bonds—interest rates (yields) move higher as prices decline due to lower demand by the investor herd. Therefore, a loose and big picture view for investment strategy is to be one step ahead of the herd—and the Federal Reserve.
Prior to and during a recession, the high credit quality, low-risk bond funds—those investing in US Treasuries and above investment-grade corporate bonds—can be a smart move. Toward the end of a recession, an investor could begin shifting into the lower credit quality, high-risk junk (high yield) bond funds. The goal is to ride prices higher as the economy improves. In summary, the best time to invest in junk bonds is in the latter stages of a recession, precisely at the time when no one else wants them.
Mutual Fund Tips and Cautions
Due to the complexities of bond investing and the risk of market timing, most investors will do well investing in a bond fund with experienced management. This way, you can leave the navigation of this complex credit world to those who understand it—the best bond fund managers.
If your investment objective is intermediate to long-term—at least 3 years or more—and you want to gain exposure to high relative risk, you might consider a fund such as Loomis Sayles Bond (LSBRX), which can invest in almost any type of bond, including junk bonds, foreign bonds, and emerging market bonds.
Of course, even the best bond fund managers can make mistakes. Therefore, you may want to look closer at some reasons why to use bond index funds.